Chapter 04 – The Accounting Cycle: Accruals and Deferrals
4 THE ACCOUNTING CYCLE:
ACCRUALS AND DEFERRALS
Chapter Summary
In order for revenues and expenses to be reported in which they are earned or incurred,
adjusting entries must be made at the end of the accounting period. Adjusting entries are made so
the revenue recognition and matching principles are followed. Chapter 4 completes the treatment
of the accounting cycle for service type businesses. It focuses on the year-end activities
culminating in the annual report. These include the preparation of adjusting entries, preparing the
financial statements themselves, drafting the footnotes to the statements, closing the accounts, and
preparing for the audit. These topics form the content of Chapter 4.
The chapter begins with a thorough review of various adjusting entries. The adjustments
are classified into four categories: converting assets to expenses; converting liabilities to revenue;
accruing unpaid expenses and; accruing uncollected revenues. The categories are discussed and
illustrated in this order. We briefly explain that the adjusting entries are needed to satisfy the
realization and matching principles. The concept of materiality is introduced and its relevance to
the adjusting entries is explained next.
Learning Objectives
1. Explain the purpose of adjusting entries.
2. Describe and prepare the four basic types of adjusting entries.
3. Prepare adjusting entries to convert assets to expenses.
4. Prepare adjusting entries to convert liabilities to revenue.
5. Prepare adjusting entries to accrue unpaid expenses.
6. Prepare adjusting entries to accrue uncollected revenue.
7. Explain how the principles of realization and matching relate to adjusting entries.
8. Explain the concept of materiality.
9. Prepare an adjusted trial balance and describe its purpose.
Brief topical outline
AAdjusting entries
1The need for adjusting entries
2 Types of adjusting entries
3 Adjusting entries and timing differences
4 Characteristics of adjusting entries
5 Year–end at Overnight Auto Service
Chapter 04 – The Accounting Cycle: Accruals and Deferrals
6Converting assets to expenses
aPrepaid expenses
b Shop supplies
c Insurance policies – see Your Turn (page 147)
d Recording prepayments directly in the expense accounts
7The concept of depreciation
a What is deprecation?
b Depreciation is only an estimate – see Case in Point (page 149)
c Depreciation of Overnight’s building
dDepreciation of tools and equipment
eDepreciation – a noncash expense
8Converting liabilities to revenue
a Recording advance collections directly in the revenue accounts
9Accruing unpaid expenses
a Accrual of wages (or salaries) expense
b Accrual of interest expense
10 Accruing uncollected revenue
11 Accruing income taxes expense: the final adjusting entry – see Case in Point
(page 155)
aIncome taxes in unprofitable periods
BAdjusting entries and accounting principles
1The concept of materiality
aMateriality and adjusting entries
bMateriality is a matter of professional judgment – see Your Turn (page
158)
2Effects of the adjusting entries – see Ethics, Fraud & Corporate Governance
(page 161)
CConcluding remarks
Topical coverage and suggested assignment
Homework Assignment
(To Be Completed Prior to Class)
Class
Meetings
on Chapter
Topical
Outline
Coverage
Discussion
Questions
Brief
Exercises Exercises Problems
Critical
Thinking
Cases
1 A 1, 2, 3 1, 2 2, 3, 6 1
2 A 8, 9 4, 5 7, 9 3, 4 1
3 B – C 10, 11 9, 10 10, 11 6 2
Comments and observations
Teaching objectives for Chapter 4
In Chapter 4 we cover the numerous accounting activities, both analytical and procedural, that
take place at the end of a fiscal year. In covering this chapter, our teaching objectives are to:
1Explain the need for adjusting entries in accrual accounting.
Chapter 04 – The Accounting Cycle: Accruals and Deferrals
2 Illustrate the four basic types of adjusting entries.
3 Review in sequence the steps in the complete accounting cycle.
4Introduce the principle of materiality and discuss its relevance to adjusting entries.
General comments
The need for adjusting entries stems from the most basic concepts of accrual accounting,
the concepts that revenue is recognized when it is earned and that expenses are recognized when
the related goods and services are used. We find that students who do not fully understand the
nature and purpose of adjusting entries have difficulty with other accrual accounting concepts
throughout the course. We find Exercises 2, 3, 5, and 9 particularly useful. Exercise 2 illustrates
the effects of the four basic types of adjusting entries upon both the income statement and balance
sheet. Exercise 3 focuses upon those adjustments that apportion previously recorded amounts,
while Exercise 5 illustrates adjustments needed to accrue unrecorded amounts. Exercise 9
demonstrates that the need for adjusting entries arises from transactions spanning more than one
accounting period. We also like Exercise 6, which focuses upon unearned revenue in the
accounting records of American Airlines.
We personally spend quite a bit of class time on materiality, as we consider it to be one of
the most important concepts in accounting. The chapter has several good assignments on
materiality, including Discussion Questions 10 and 11, Exercise 10, and Case 2. We always assign
at least two of these and discuss them in class.
An aside Some students may ask why the word “debit” is abbreviated “Dr.” in the columnar
headings of the worksheet, as there is no “r” in “debit.” The word “debit” is derived from the
Latin verb debere, which means “to owe.” “Credit“ stems from the Latin verb credere, meaning
“to entrust” or “to lend.” In modern usage, of course, the term debit has come to mean any entry
in the left-hand side of a ledger account, and credit has come to mean any entry in the right-hand
side.
Supplemental Exercises
Group Exercise
Have students interview accounting managers at several corporations in the local area.
Ask students to find out how often the corporation prepares adjusting entries and how important
the accounting manager thinks adjusting entries are to the fair presentation of the financial
statements to the stockholders and creditors.
Internet Exercise
Visit the homepage of Microsoft at www.microsoft.com. Access the annual report for
2009. Find the footnotes to the statements and read the disclosures in the note titled
Financial Accounting, 16e 4- 3
Chapter 04 – The Accounting Cycle: Accruals and Deferrals
“Contingencies.” Regarding the events described do you think Microsoft is providing adequate
disclosure to its stockholders?
CHAPTER 4 NAME #
10-MINUTE QUIZ A SECTION
Indicate the best answer for each question in the space provided.
1Joseph Jewelers purchased display shelves on March 1 for $36,000. If this asset has an
estimated useful life of five years, what is the book value of the display shelves on April 30?
a$600. b$34,800. c$33,600. d$900.
2The adjusting entry to recognize an unrecorded expense is necessary:
aWhen an expense is paid in advance.
bWhen an expense has been neither paid nor recorded as of the end of the accounting
period.
cWhenever an expense remains unpaid at the end of an accounting period.
dBecause the accountant is likely to forget to pay these unrecorded expenses.
3Before any month–end adjustments are made, the net income of Lawrence Company is
$550,000. However, the following adjustments are necessary: office supplies used,
$35,000; services performed for clients but not yet recorded or collected, $12,300; interest
accrued on note payable to bank, $14,100. After adjusting entries are made for the items
listed above, Lawrence Company’s net income would be:
a$541,400.
b$488,600.
c$583,200.
d$513,200.
4Of the following adjusting entries, which one results in an increase in liabilities and the
recognition of an expense at the end of an accounting period?
5The CPA firm auditing Indian Company found that net income had been overstated. Which
of the following errors could be the cause?
aFailure to record depreciation expense for the period.
bNo entry made to record purchase of land for cash on the last day of the year.
cFailure to record payment of an account payable on the last day of the year.
dFailure to make an adjusting entry to record revenue which had been earned but not yet
billed to customers.
CHAPTER 4 NAME #
10-MINUTE QUIZ B SECTION
Manhattan Park adjusts its books each month and closes its books on December 31 each year.
The trial balance at January 31, 2010, before adjustments, follows:
Debit Credit
Cash……………………………………………………….…………….... $ 6,600
Supplies………………………………………………………….…..……. 5,400
Chapter 04 – The Accounting Cycle: Accruals and Deferrals
Unexpired Insurance..………….………….…............................. 12,600
Equipment……………………………………………………………….... 72,000
Accumulated Depreciation: Equipment.………….…................ $ 18,000
Unearned Admission Revenue……………………………………….. 12,000
Capital Stock…………………………………………….…..………….. 20,000
Retained Earnings, January 1, 2010……………………………….. 38,200
Admissions Revenue.……………….……………......................... 27,600
Salaries Expense………………………………………….…..………… 8,100
Utilities Expense…………………….………………....................... 5,700
Rent Expense……………………………………………....……………. 5,400 _________
$115,800 $115,800
1Refer to the above data. According to attendance records, $8,200 of the Unearned
Admission Revenue has been earned in January. Compute the amount of admissions
revenue to be shown in the January income statement:
a$35,800. b$19,400. c$8,200. d$3,800.
2Refer to the above data. At January 31, the amount of supplies on hand is $2,300. What
amount is shown on the January income statement for supplies expense?
a$2,300. b$5,400. c$3,100. d$7,700.
3Refer to the above data. The equipment has an original estimated useful life of six years.
Compute the book value of the equipment at January 31 after the proper January
adjustment is recorded:
a$1,000. b$71,000. c$53,000. d$60,000.
4Refer to the above data. Employees are owed $1,200 for services since the last payday in
January to be paid the first week of February. No adjustment was made for this item. As a
result of this error:
aAssets at January 31 are overstated.
bJanuary net income is overstated.
cLiabilities at January 31 are overstated.
dOwners’ equity at January 31 is understated.
5Refer to the above data. On August 1, 2009, the park purchased a 12-month insurance
policy. The necessary adjusting entry at January 31 includes which of the following entries?
(Hint: The company has adjusted its books on a monthly basis.)
aA debit to Insurance Expense for $1,050.
bA credit to Unexpired Insurance for $11,550.
cA credit to Unexpired Insurance for $1,800.
dA debit to Unexpired Insurance for $10,800.
\ CHAPTER 4 NAME #
10-MINUTE QUIZ C SECTION
Scorpio Travel adjusts its books each month and closes its books on December 31 each year. The
trial balance at January 31, 2009, before adjustments, follows:
Debit Credit
Cash……………………………………………………….…………….... $ 3,300
Supplies………………………………………………………….…..……. 2,700
Unexpired Insurance..………….………….…............................. 6,300
Equipment……………………………………………………………….... 36,000
Accumulated Depreciation: Equipment.………….…................ $9,000
Unearned Admission Revenue……………………………………….. 6,000
Financial Accounting, 16e 4- 5
Chapter 04 – The Accounting Cycle: Accruals and Deferrals
Capital Stock…………………………………………….…..………….. 7,500
Retained Earnings, January 1, 2009……………………………….. 21,600
Admissions Revenue.……………….……………......................... 13,800
Salaries Expense………………………………………….…..………… 4,050
Utilities Expense…………………….………………....................... 2,850
Rent Expense……………………………………………....……………. 2,700 ________
$57,900 $57,900
1Refer to the above data. According to attendance records, $4,800 of the Unearned Admission Revenue
has been earned in January. Compute the balance in the following accounts after the proper adjustment is
made.
Unearned Admission Revenue account balance $__________
Admission Revenue account balance $__________
2Refer to the above data. At January 31, the amount of supplies still on hand was determined to be $675.
What amount should be reported in the January income statement for supplies expense? $__________
3Refer to the above data. The equipment has an original useful life of eight years. Compute the book
value of the equipment at January 31 after the proper January adjustment is recorded. $__________
4Refer to the above data. $900 is owed to employees for work since the last payday in January, to be paid
the first week of February. What is the effect on January net income if the accountant fails to make any
January 31 adjustment for this item? $__________
6Refer to the above data. On June 1, 2008, the park purchased a 12-month insurance
policy. Give the adjusting entry to record insurance coverage expiring in January.
(Hint: The company adjusts its books on a monthly basis.)
7 CHAPTER 4 NAME …………………………………..……….
# ……………………………….………..
10-MINUTE QUIZ D SECTION
The accountant for Rose’s Emporium, Inc. prepared the following trial balance at January 31, 2010, after one
month of operations:
Debit Credit
Cash…………………………………………………………………………………………. $ 5,700
Accounts Receivable………………………………………………...……………..….. 4,500
Unexpired Insurance…………………………………………………………………….. 2,100
Office Equipment…………………………………………………..……………..…….. 18,000
Unearned Consulting Fees………..…….……………….………......................... $ 3,300
Capital Stock………………………………………………………………………………. 15,600
Retained Earnings, January 1, 2010………………………………………………… 0
Dividends…………………………………………………………………………..………. 3,300
Consulting Fees Earned………………………………………………..…..………….. 26,800
Salaries Expense………………………………………………………..…………..…… 7,700
Utilities Expense………………………………………………………………………….. 1,700
Rent Expense………………………………………………………...……………..……. 2,100
Supplies Expense…………………………………………………………..……………. 600 ______
$45,700 $45,700
Additional information items:
aConsulting services rendered to a client in January, not yet billed or recorded, $2,400.
bPortion of insurance expiring in January, $300.
Chapter 04 – The Accounting Cycle: Accruals and Deferrals
cIncome taxes expense for January of $2,500.
dThe office equipment has a life of 5 years.
Instructions. Prepare adjusting entries for a through d.
Adjusting Entries
Jan. 31
SOLUTIONS TO CHAPTER 4 10-MINUTE QUIZZES
QUIZ A QUIZ B
1B1A
Learning Objective: Learning Objective:
3 – 6 3, 4, 5
QUIZ C
1
Chapter 04 – The Accounting Cycle: Accruals and Deferrals
Jan 31
a Accounts Receivable 2,400
Consulting Fees Earned 2,400
b Insurance Expense 300
Chapter 04 – The Accounting Cycle: Accruals and Deferrals
Assignment Guide to Chapter 4
Brief
Exercis
es
Exercises Problems Cases Net
1 – 10 1 – 15 1 2 3 4 5 6 7 8 1 2 3 4
Time estimate (in minutes) < 10 < 15 40 40 40 25 30 60 60 60 30 25 10 10
Difficulty rating E E M M M S M S S S M M E E
Learning Objectives: 1, 2, 3, 4, 5, 6,
7, 8, 9, 10, 11,
1. Explain the purpose
entries to convert
liabilities to revenue. 1, 2, 6
7, 9, 10, 11,
12, 13, 14
√ √ √
5. Prepare adjusting
entries to accrue
unpaid expenses.
7, 8, 9
1, 2, 3, 4, 5,
7, 8, 9, 10, 12,
13, 14
√ √
6. Prepare adjusting
1, 2, 3, 4, 5,
matching relate to
adjusting entries.
8. Explain the concept of
materiality.10 1, 14
9. Prepare an adjusted
trial balance and
describe its purpose. 1, 2, 7, 9, 12